It was not only the unseasonably warm weather in southern Europe last week that caused tempers to flare. Concerns about inflation and rising interest rates sent European bond markets crashing, with traders feeling the heat. Thankfully, the European Central Bank (ECB) in Frankfurt moved swiftly by calling an “emergency meeting”, reiterating that it was “firmly committed to contain unwarranted fragmentation” in the Eurozone, according to ECB board member Olli Rehn. The bond market was tamed and calm restored, but fears remain.
The Eurozone is a strange, chimeric beast. Used by 19 of the 27 member states of the European Union, it has always seemed more of a political project than one that makes clear economic sense. While there is one currency for all Eurozone countries, all member states issue their own debt.
Although European federalists continue to have lofty dreams of one day achieving fiscal union and “completing” the unfinished economic block, it remains a far-off prospect. Progress since its launch in 2000 has been made, with things like the European Stability Mechanism acting as a fiscal backstop and the Next Generation EU recovery fund providing fiscal support to highly indebted member states. However, despite these positive incremental steps, concerns about the structural stability at the heart of the sovereign bond market in Europe have never been entirely resolved.
Such deficiencies were laid bare at the peak of the Eurozone crisis, between 2011 and 2015, when European leaders had to confront the chance of a break-up of the single currency. The then president of the ECB, Mario Draghi, famously saved the day by declaring he was ready to do “whatever it takes to preserve the Eurozone, and believe me it will be enough”. However, while the difference in yields between “core” bonds (such as Germany) and the “periphery” (such as Portugal, Italy, Ireland, Greece and Spain – the infamous PIIGS) subsequently narrowed, they never disappeared entirely.
Inflation in Europe changes everything, and markets know it. Fundamentally, the ECB’s support for the bond market was always conditional on its ability to continue delivering its mandate of price stability. The persistent threat of deflation enabled it to provide the limitless support required to halt fears of fragmentation.
Last week, in response to the highest inflation since the inception of the common currency, ECB President Christine Lagarde stated she was planning to hike interest rates from September. Bonds, particularly of the PIIGS countries, sold off. Once again, worries about Eurozone fragmentation resurfaced. The epicentre of these concerns is now Italy, not Greece. Italian debt-to-GDP is at an eye-watering 150%. Its bond yields have jumped from 0.5% to almost 4% in under a year (bond yields move inversely to prices). If the ECB had not called its “emergency meeting”, they could have spiked even higher towards the danger zone of debt unsustainability.
At the heart of the issue is a strange game of chicken between the ECB and investors. In the case of the ECB, it is a balancing act between defending the integrity of the single currency and also acting within its mandate of not directly financing deficits. Investors exploit this and are willing to sell to push yields up and up, right to breaking point, when the ECB blinks and promises direct intervention. At that point, bond investors simply buy back in and pocket a tidy profit, a trade already christened “the Lagarde Put”.
If all this sounds trite and unnecessary, that’s because it is. The reality though is that inflation and the need to raise rates do create an extremely difficult situation for the ECB. A “tool” to prevent fragmentation by implicitly targeting sovereign spreads essentially means the ECB would have to be willing to intervene in the market and buy up bonds of a country that was facing a run on its debt, a policy which would be construed as being essentially inflationary. To contain inflation, the ECB should be selling debt and drawing money out of the system, not buying.
Once again, the ECB will have to say it will not do something while making it clear to investors that it would absolutely be willing to do exactly that, daring them to blink first. It will be a test of Lagarde’s mettle as a central banker that she is able to pull off this tightrope act without setting off another market meltdown. Clarity on how she proposes to do this will have to be forthcoming or markets will be forced to draw their own conclusions. DM/BM
This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R25.